Alpha Theory Blog - News and Insights

1 posts from April 2014

April 29, 2014

This article was co-written by Benn Dunn, President of Alpha Theory Advisors, and Cameron Hight, CEO of Alpha Theory.

March and April 2014 are turning out to be an agonizingly painful period for equity long/short managers second only to 2008 in the severity of the drawdown. Unlike 2008, the market is significantly outperforming hedge fund managers making the pain all the more acute. Currently the popular explanation for the hedge fund unwind began with Yellen's "six months" foot in mouth comment regarding potential Fed rate hikes. This in conjunction with tensions in the Ukraine, a series of dubious acquisitions by Facebook, poor IPO performance, and significantly dilutive secondary offerings in the IT sector provided some justification as the catalyst for the unwind (for an alternative and more likely explanation see Ben Hunt's "Beta Earthquake" note: http://www.salientpartners.com/epsilontheory/pdf/emails/4.13.2014%20Beta%20Earthquake.pdf).

The initial hot spot for the losses in equity long/short space were felt most acutely in Biotech and IT. The reversals in market neutral quant factors like six month momentum and Growth were breathtaking in both their size and speed. Gains that accrued over seven months were obliterated in less than 20 days. Additional losses accrued to equity long/short managers as the unwind moved from sector specific names into "crowded" thematic trades. The losses accelerated as hedge funds, flush with newly acquired capital, and bursting with leverage (http://www.zerohedge.com/news/2014-04-09/these-are-most-levered-hedge-funds) took "risk" down.

While the unwind has shown signs of abating over the last week or so, additional moves on April 25th indicate that there is still some downside. The important question for managers is whether or not they could have managed their portfolio differently. Using the ratio of Morgan Stanley's New Tech to Old Tech basket as a proxy for an IT specific long/short market neutral strategy we find it surprising that a manager wouldn't reduce exposure during the 70% run up from June through February. All things being equal, position sizes were increasing in assets that had falling expected returns (getting closer to upside targets and further away from downside targets).

This is where Alpha Theory comes in. One of the many benefits of Alpha Theory is that as stocks move towards an analyst's targets, the investment team is alerted to reassess their projections. Sometimes the facts have changed, targets need to be raised, and the larger position size is justified. But more likely, the position should be trimmed. Trading around the intrinsic value of positions has multiple positive benefits, including:

1. Moving capital into higher expected return ideas

2. Reducing portfolio volatility by reducing exposure to assets that have run

3. Taking advantage of the mean-reverting nature of the market

4. Creating dry powder, so that if the stock pulls back, you can add with confidence

Trimming positions that have run is, many times, obvious in hindsight. Putting systems and procedures in place, like those codified by Alpha Theory, are the best way to make these triggers explicit so that they're not ignored at times when it is most important to heed.